What's important - Security of Loan or Loan Purpose???

[TheShuffler]

Hi - from a tax deductability point of view, is the loan security the important or the purpose of the loan (ie that the funds are used for investment?).
Thanks

 

[Rolf Latham]

Mostly the PURPOSE of the funds

but there are some fiddly exceptions

ta
rolf

 

[TheShuffler]

Ok - second part to question; if I sell investment but still have loan (which wasn't secured against investment); what do I do with the interest assuming I decided to keep the proceeds of the investment sale under my mattress (ie not repay capital debt). This is the part that I'm really struggling with..

 

[Rolf Latham]

Id guess the loan is no longer deductible since the income producing asset no longer exists.

ta
rolf

 

[bene313]

It's the use of the funds which determines deductibility.

So, if you sell the asset and recoup the funds but do not pay the loan back, you must be allocating those funds elsewhere, hence, the use of the funds has now changed. The new use of those funds will therefore determine deductibility of the loan.

 

[TheShuffler]

Thanks guys - last question on this track. I have a loan against my PPR for the purposes of investing in shares. The loan (LoC) and PPR are in mine and my wifes name however I will be buying shares in my name only. Can I deduct 100% of the interest on my tax return (as the investment is in my name) or only 50% because the loan is in both of our names?

AND if the shares go up and I sell part of them, however the still have an outstanding loan, should I be paying down the value of the shares I have sold? Kind of like taking the capital gain from an IP however is different due to the fact the 'unit' holding will change. Unless I have reinvested dividends...this is doing my head in.

I have a good accountant and will be asking him however am just asking the questions as I think of them.
Cheers

 

[Rolf Latham]

with a loan in joint names we like to apply the income test.

Where do the dividends ( and or capital gain) go and who pays the income tax, clearly, in this case at least the owner of the asset.

Id be looking to repatriate that part of the dedbt that related to the share purchase so that you can then reborrow.

But thems just my musings, I aint no Tax guy

ta
rolf

 

[brendio]

Thanks guys - last question on this track. I have a loan against my PPR for the purposes of investing in shares. The loan (LoC) and PPR are in mine and my wifes name however I will be buying shares in my name only. Can I deduct 100% of the interest on my tax return (as the investment is in my name) or only 50% because the loan is in both of our names?

You could make the argument that your wife has effectively loaned you the other 50% and you are paying her interest at the relevant rate. She would then be getting interest from you and having to pay interest to the bank of the same amount, so it would have no effect on her tax situation (gets interest, which adds to her income, and pays interest, which deducts from it). Check with your accountant whether a formal loan agreement is required, and also whether there would be any effect on centrelink entitlements (they sometimes calculate income differently to the ATO).

AND if the shares go up and I sell part of them, however the still have an outstanding loan, should I be paying down the value of the shares I have sold? Kind of like taking the capital gain from an IP however is different due to the fact the 'unit' holding will change. Unless I have reinvested dividends...this is doing my head in.

I have a good accountant and will be asking him however am just asking the questions as I think of them.
Cheers

It helps to think in terms of capital and income. Your loan is used to make a capital purchase, which then provides income in the form of dividends. The income you can do with as you please, but the deductibility of the interest on the loan depends on where the capital is allocated. Hence, when you sell, you realise that capital in the form of cash and you need to either reallocate it to income producing purposes to maintain deductibility or use it to pay off the loan. Dividend reinvestment would be a tricky situation, since you are reinvesting income back into capital. The DRP shares are bought with your own money, not the loan. You could argue that the money from DRP shares sold does not need to pay the loan off (i.e. could be used personally), but in reality, they are mixed in with the other shares in your portfolio so it would be a mess to untangle without contaminating your loan.

Once you understand the concepts of the difference between capital and income, you can then go about looking at creative ways of converting between the two. For example, say you want to get some cash from your margin loan/LOC portfolio for personal use without contaminating the loan. You could look at buying high yielding shares before they go ex-div to pick up the dividend and then sell (presumably at a loss) after it goes ex-div. (Beware of the 45-day rule if doing this for large sums.) Share buybacks such as WOW has just had and BHP has announced are great for converting capital to income. These involve selling your shares back to the company in return for a small capital sum and a larger franked dividend component.

Okay, now that I think I've answered your question, may I ask one of my own on the same topic? Say you borrow $10k to buy XYZ shares. You also have borrowed for other shares in your portfolio. A year later your XYZ shares are worth $15k and you sell them. Does the entire $15k proceeds need to be applied to the loan or could you pay off just $10k and use the rest for a holiday? What if instead your XYZ shares were only $5k when you sell them are pay the proceeds off your loan. You then still have $5k debt, but no longer have the original asset for which the loan was used. Does the interest continue to be deductible?

I think I know the answer, but am interested in hearing other people's take on it.

 

[Rob G.]

I think I know the answer, but am interested in hearing other people's take on it.

How about the ATO's opinion, TR 93/32.

Cheers,

Rob

 

[Terryw]

How about the ATO's opinion, TR 93/32.

Cheers,

Rob

TR 93/32
Income tax: rental property - division of net income or loss between co-owners
http://law.ato.gov.au/atolaw/view.htm?docid=TXR/TR9332/NAT/ATO/00001

 

[Terryw]

Okay, now that I think I've answered your question, may I ask one of my own on the same topic? Say you borrow $10k to buy XYZ shares. You also have borrowed for other shares in your portfolio. A year later your XYZ shares are worth $15k and you sell them. Does the entire $15k proceeds need to be applied to the loan or could you pay off just $10k and use the rest for a holiday? What if instead your XYZ shares were only $5k when you sell them are pay the proceeds off your loan. You then still have $5k debt, but no longer have the original asset for which the loan was used. Does the interest continue to be deductible?

I think I know the answer, but am interested in hearing other people's take on it.

I think Rob, missed this bit.

Once the shares are sold at a loss is any interest on the loan remaining deductible?

I think the answer is possibly yes.

FCT v. Jones 2002 ATC 4135; (2002) 49 ATR 188
http://law.ato.gov.au/atolaw/view.htm?locid='JUD/2002ATC4135'&PiT=99991231235958
(this taxpayer didn't make a voluntary decision not to pay the loan, but couldn't afford to)

FCT v. Brown 99 ATC 4600; (1999) 43 ATR 1
http://law.ato.gov.au/atolaw/view.htm?locid='JUD/99ATC4600'&PiT=99991231235958

These cases gave rise to
TR 2004/4
Income tax: deductions for interest incurred prior to the commencement of, or following the cessation of, relevant income earning activities
http://law.ato.gov.au/atolaw/view.htm?docid=TXR/TR20044/NAT/ATO/00001

See:

Interest incurred after assessable income

10. Where interest has been incurred over a period after the relevant borrowings (or assets representing those borrowings) have been lost to the taxpayer and relevant income earning activities (whether business or non-business) have ceased, it is apparent that the interest is not incurred in gaining or producing the assessable income of that period or any future period. However, the outgoing will still have been incurred in gaining or producing 'the assessable income' if the occasion of the outgoing is to be found in whatever was productive of assessable income of an earlier period.

11. Whether or not the occasion of the outgoing of interest is to be found in what was productive of assessable income of an earlier period requires a judgment about the nexus between the outgoing and the income earning activities.

12. An outgoing of interest in such circumstances will not fail to be deductible merely because:

·
the loan is not for a fixed term;

·
the taxpayer has a legal entitlement to repay the principal before maturity, with or without penalty; or

·
the original loan is refinanced, whether once or more than once.

13. However, if the taxpayer:

·
keeps the loan on foot for reasons unassociated with the former income earning activities; or

·
makes a conscious decision to extend the loan in such a way that there is an ongoing commercial advantage to be derived from the extension which is unrelated to the attempts to earn assessable income in connection with which the debt was originally incurred,

the nexus between the outgoings of interest and the relevant income earning activities will be broken.

14. A legalF2 or economicF3 inability to repay is suggestive of the loan not having been kept on foot for purposes other than the former income earning activities.

 

[Rob G.]

Hi Terry,

Case Law is from active business, not passive investment.

Also, these did not involve *recurrent* refinancing such as a LOC. Refinancing your capital losses is fraught with pitfalls.

With a LOC and investment losses, note example 5 to TR 2000/2.

Of course, this is only a ruling and not law.

Cheers,

Rob

 

[Terryw]

thanks Rob

Interesting, example 5:
http://law.ato.gov.au/atolaw/view.htm?docid=TXR/TR20002/NAT/ATO/00001

Example five

70. All facts are the same as in example four except Bob sells all the XYZ shares for $8,000 and pays that amount into the mixed purpose sub-account.

71. For a line of credit, the deductibility of interest depends upon the continued use of borrowed funds for income producing purposes. After the sale of the XYZ shares, there are no longer any outstanding funds then used for income producing purposes. Therefore, there would be no deduction allowed for interest accruing on the outstanding line of credit debt after the sale of the XYZ shares.

72. The $22,000 outstanding after the sale of the shares and repayment of the sale proceeds, comprises $20,000 of borrowed funds that continue to be applied to the purchase of a private vehicle and $2,000 of borrowed funds still outstanding that was lost on the sale of the income producing shares. After the sale of those shares, the outgoing of interest on that $2,000 ceases to be for the purpose of retaining the use of those funds for income producing purposes. The interest incurred after the sale relates to financing the capital loss made on the sale of those shares. The connection with the previous income producing use of the funds invested in the XYZ shares is broken on the sale of those shares. The 'occasion' of the incurring of that interest is no longer the obligation to pay interest under the terms and conditions applicable to the previous period of the borrowing arrangement.

73. No deduction would be allowable under s 8-1 ITAA 1997 in respect of interest on the borrowed funds lost on the sale of the income producing XYZ shares.